WASHINGTON -- The Supreme Court yesterday agreed to review the constitutionality of California's old system of taxing multinational corporations -- a decision that could cost the state $4 billion if it loses.

In other action yesterday, the justices also agreed to review New York State's efforts to collect taxes on cigarette sales made by Indian merchants.

In the California dispute, the court agreed to review two separate cases, Barclays Bank v. Franchise Tax Board and Colgate-Palmolive Co. v. Franchise Tax Board. The justices consolidated the cases and said they would allot a total of one and a half hours for oral argument. The court normally reserves just an hour for argument, even in consolidated cases.

No date was set for the argument, but the case probably will be reviewed sometime in the spring.

At issue in the Barclays case is whether California's past use of worldwide combined reporting to determine the taxable income of foreign corporations violated the U.S. Constitution's foreign commerce clause.

The Colgate-Palmolive Co. case raises the issue, of whether California's past use of worldwide combined reporting violated the Constitution's domestic commerce clause.

Both constitutional clauses give Congress the exclusive right to regulate trade. They generally have been construed by the high court as barring states from erecting-barriers to the free flow of goods and services across political boundaries.

Under worldwide combined reporting, all the income of all the entities that form a business are considered in aggregate in determining a company's tax burden.

By contrast, the internationally accepted method for figuring out a multinational company's tax liability is the arm's length method, under which each corporation within a business is treated as an independent entity dealing at arm's length with its affiliated corporations. That method subjects a company to taxation only by the jurisdictions in which it operates and only for the income it realizes on its own books.

The arm's length method generally results in a lower tax liability and has a lower compliance cost than worldwide combined reporting. As a consequence, California's use of worldwide combined reporting has touched off an international furor that has threatened to erupt into a trade war. The United Kingdom, for example, said earlier this year that would take retaliatory measures against U.S. corporations unless California dropped worldwide combined reporting by the end of the year.

But for California, a ruling overturning the tax could result in a substantial refund liability. California Board of Equalization Chairman Brad Sherman yesterday said the state could be forced to refund $1.7 billion in taxes and cancel $2.3 billion in pending assessment cases if the high court strikes down the tax.

On Oct. 6, California Gov. Pete Wilson signed a bill changing state law to allow multinational firms to choose to be taxed on an arm's length basis and removed impediments that would have made such an election burdensome. The changes prompted the U.S. government to urge the Supreme Court not to review the dispute.

In a brief filed with the court by Solicitor General Drew S. Days 3d, the federal government said, "California's recent modifications of its tax system have brought that state's law into acceptable harmony with federal and international arm's length tax practice.

"A decision by this court on the constitutional question posed in this case is thus unnecessary to achieve adequate consistency in the nation's regulation of foreign commerce, which California has striven to accomplish through its voluntary action."

But the government of the United Kingdom, in a friend-of-the-court brief filed on behalf of U.K.-based Barclays Bank, said it would not be comfortable until "the internationally accepted arm's length principle is endorsed, on a permanent basis, as the only valid method of taxing foreign companies."

Sherman of the equalization board said he was disappointed the court agreed to review the disputes, but said he was heartened that the Clinton Administration supported the state's position.

"These two cases involve $4 billion for California and losing them would be more than twice as disastrous in economic terms as the recent Southern California fires," Sherman said in a statement. "A strong brief on the merits from the Clinton Administration should extinguish this threatened fiscal fire storm."

Coby A. King, legal counsel to Sherman, said he expects the Justice Department to file a new brief on the merits of the case now that it is before the high court.

In addition, Barclays Bank is expected to file a brief by Dec. 16, King said. The California Franchise Tax Board will file its brief by Jan. 16, he said.

In the New York case, Department of Taxation and Finance v. Milhelm Attea & Bros. Inc., the state is attempting to revive regulations aimed at preventing the loss of an estimated $65 million in tax revenue annually arising from the sale of cigarettes to non-Indians by retailers on Indian reservations.

In general, cigarettes sold within the state are required to bear tax stamps. But under federal law, states are not empowered to collect taxes on sales made on Indian reservations when the transactions are between Indians.

The regulations in question allow retail dealers of cigarettes on Indian reservations to purchase enough untaxed cigarettes to satisfy the needs of Indian customers. But the regulations also require those retailers to have taxed and stamped cigarettes available for sale to non-Indians. The regulations are enforced through requirements that wholesalers be liable for, and collect the taxes on, all sales to Indian retailers except for the limited amount deemed adequate to meet Indian cigarette demand.

The regulations were successfully challenged by Milhelm Attea & Bros., a cigarette wholesaler that is federally licensed as an "Indian trader." On June 10, 1993, the New York Court of Appeals ruled that Congress has chosen to regulate Indian traders in such a comprehensive way that states have no latitude to impose additional burdens upon them. The case likely will be reviewed sometime in the spring.

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